Your credit score is arguably one of the most important numbers in your financial life. It can impact many areas of your life, including your ability to rent an apartment, purchase a car, or even get a job. If you’re in the market to buy your first home, having a good credit score can be the difference between being able to buy now or having to continue to rent.
In this article we’ll take a closer look at what’s included in your credit report and the factors that impact your credit score so that you’re prepared before you start house-hunting.
What is a Credit Report and Why is it Important?
A credit report is a collection of information about you that is shared with potential creditors, lenders and other businesses that use credit information when deciding whether to do business with you. It helps creditors determine if they’ll extend credit or approve a loan. It also helps determine what interest rate you will pay.
The three major credit reporting agencies — Experian, Equifax and TransUnion — collect and maintain data on the credit usage of millions of Americans. These agencies provide access to this information to lenders and other creditors that want to verify an applicant’s ability to repay debt.
For example, if you apply for a home loan, the lender will check your credit report with one or all of these credit agencies and review your credit history If you get approved, your credit history will impact the loan program and interest rate offered by the lender. Many lenders have minimum credit thresholds that borrowers must meet to qualify for a home loan. So what information is shared on a credit report anyway?
We’re glad you asked.
What Information is Included in a Credit Report?
Your credit report includes your name, plus any aliases that you’ve used such as a maiden name, your residential address – current and past, your social security number, open and closed accounts, and information accessible via public records.
Account information includes the type of account – for example, installment loans that have fixed payments such as a mortgage or auto loan, and revolving debt such as credit cards. Other information includes payment history, outstanding balances,length of credit history, applications for new credit accounts, the closing date for any accounts that are closed, the total number of payments made, and any late payments made.
Your credit report will also show any bankruptcies you’ve had in the last seven to ten years as well as foreclosures in the last seven years.
Your credit report will also show your credit score. In a nutshell, your credit score is a number that reflects your ability to pay by rating your credit risk. This score can range from 300 to 850 and there are several factors that determine the overall score. It’s critical to understand those factors so that you can take actions to improve and maintain your score.
In the graphic below, Experian does a nice job breaking down the different ranges from exceptionally good credit to poor credit, and includes the percentage of Americans that fall into each category.
Source: Experian
To qualify for a mortgage, a credit score of at least 500 is typically needed for a government insured loan like an FHA loan while a minimum credit score of around 620 is needed for a conventional loan. An even higher credit score of 680 or 700 is typically needed for a jumbo loan.
How Your Credit Score is Determined
There are five factors that make up your credit score: your payment history, the balances owed on your accounts, the length of credit history, recency of new credit, and the types of accounts contained in your report. Below is an illustration of the five factors that determine your credit score and the impact of each factor. Below, we’ll break down each factor.
Source: FreddieMac
Payment History: 35%
Your payment history has the biggest impact on your credit score. It accounts for 35% of the score. The payment history illustrates how you’ve paid your credit accounts in the past. A late payment can be a sign that you might not be ready for a huge financial commitment like a home mortgage – especially if your credit report shows that you’re having difficulty managing your expenses.
Making all of your payments on time and paying each of your revolving credit accounts (like credit cards) in full each month will help your credit score. Paying one or more of your payments late (typically more than 30 days past the due date), or missing a payment altogether will hurt your score, knocking it down as much as 100 points, and once you’ve made a late payment it could take many months and even years for your credit score to recover. According to a study conducted by credit score pioneer, FICO, a 30-day late payment could take anywhere from nine months to three years to recover, depending on your starting credit score. A 90-day late payment could take up to seven years to recover. Making your payments on time is critical in maintaining good credit.
Balances Owed: 30%
The second most important factor in your credit score is the amount of debt that you owe and how much of your available credit is being used. This accounts for 30% of your credit score.
Generally, creditors such as lenders like to see that you are using less than 20% of your available credit on any given credit card. Using 20% or less of your available credit shows that you’re able to manage your debt without relying too much on credit and being over-leveraged. If keeping your usage to 20% or less is not possible, then keeping your credit card balances less than 50% of your available credit will keep your credit score from plummeting. Using more than 50% of your available credit could signal that you are not managing your expenses responsibly and are overextended every month.
Length of Credit History: 15%
The length of your credit history is very important and makes up 15% of your credit score. The longer you’ve been using credit and the more accounts you’ve managed responsibly over the years, the better your credit score will be than if you just started using credit recently. A longer credit history shows creditors that you’re more established and predictable as a borrower and that you’re able to manage your spending. For example, having a home or car loan open for 5 years will give you more of a credit boost than having one open for 2 years.
If you’re a new credit user, know that your credit score will be lower in the first few years as you work to establish your payment history. This means that you may pay higher interest rates on credit cards and loans because there’s not enough data to show creditors that you’re able to manage your payments. The longer your payment history, the more available data for lenders to consider when determining whether to approve you for a loan – and at what interest rate.
New Credit: 10%
New credit accounts make up 10% of your total credit score. This factor looks at the number of new accounts you’ve opened recently. New accounts that were opened within the past two years are not factored into this section but are considered in other factors such as length of credit history and account types. New credit only looks at how many new accounts you’ve opened within the past year and how many times you have applied for credit. If you’re opening many new accounts, it can hurt your score because it could signal that you’re having difficulty managing your money and are relying on credit cards to make ends meet.
New credit also factors in the number of credit inquiries you have on your credit report, which is the number of times that creditors check your credit when you apply for credit cards or loans. Having your credit run once or twice over a short period of time won’t negatively impact your score much, but having six or more over a six-month period could drop your score significantly. Hard inquiries stay on your credit report for about two years.
Type of Accounts: 10%
The types of accounts that you have make up the final 10% of your overall credit score. Lenders like to see a mix of revolving credit such as credit cards as well as installment loans such as mortgages, home equity loans, and auto loans, so it’s important that the type of credit accounts you have are not too similar. The reason for this is because lenders want to see that you can manage multiple types of debt at once. It’s similar to having multiple subjects in school such as math, history, and science. Like being a well-rounded student, lenders like seeing well-rounded borrowers who can manage different types of accounts responsibly. If you only have one type of account, your overall credit score will suffer. For example, someone that only has a mortgage account would likely have a lower credit score than someone with different types of accounts such as a credit card and an auto loan – all else being equal.
Therefore, it’s a good idea to have at least one installment loan, such as a car loan and one revolving account such as a credit card.
The Takeaway
Your credit history is one of the most important factors in determining whether you can get approved for new credit such as a car loan, credit card, or home loan. It can even impact your ability to get a job. In the case of a home loan, it can affect which loan programs you qualify for and the interest rate and monthly payment offered. The good news is, there are many loan programs available for first-time home buyers and for borrowers with less than perfect credit, so it’s best to speak with a lender before you begin house-hunting so you can see what options are available and what you can afford.
Paying bills on time and keeping your debt balances low are the most effective ways to improve your credit score. The better your credit, the more options you’ll have for financing and the more money you can keep in your pocket when purchasing a home.
